Part III.

Administrative, Procedural, and Miscellaneous

26 CFR 601.201: Rulings and determination letters.

(Also, Part I, §§79, 83, 402; §§1.79-1, 1.83-3, 1.402(a)-1.)

Rev. Proc. 2005-25

SECTION 1. PURPOSE

This revenue procedure provides guidance on how to determine the fair market

value of a life insurance contract, retirement income contract, endowment contract, or

other contract providing life insurance protection for purposes of applying the rules of §§

79, 83 and 402 of the Internal Revenue Code. Rev. Proc. 2004-16, 2004-10 I.R.B. 559,

is modified and superseded.

SECTION 2. BACKGROUND

.01 Relevance of Fair Market Value

(1) Distributions from Qualified Plans Under § 402(a). Section 402(a) provides

generally that any amount actually distributed to any distributee by any employees' trust

described in § 401(a) (which is exempt from tax under § 501(a)) is taxable to the

distributee, in the taxable year of the distributee in which distributed. Section 1.402(a)-

1(a)(1)(iii) of the Income Tax Regulations provides, in general, that a distribution of

property by a qualified plan is taken into account by the distributee at its "fair market

value." Section 1.402(a)-1(a)(2) provides, in general, that upon distribution of a

retirement income, endowment, or other life insurance contract, the "entire cash value"
 2

at the time of distribution must be included in the distributee's income. Amendments to

the regulations under § 402 were proposed on February 13, 2004 (69 FR 7384) to

clarify that the fair market value standard controls when such a contract is distributed.

The same valuation standard applies when such a contract is sold by the plan to a

participant. This fair market value standard under the proposed regulations would apply

to distributions or sales that occur on or after February 13, 2004.

(2) Permanent Benefits Provided Under § 79. Section 79 generally requires

that the cost of group-term life insurance coverage on the life of an employee that is in

excess of $50,000 of coverage be included in the income of the employee. Pursuant to

§ 1.79-1(b) of the regulations, under specified circumstances, group-term life insurance

may be combined with other benefits, referred to as permanent benefits. Under § 1.79-

1(d), the employee’s income includes the cost of those permanent benefits, reduced by

the amount the employee paid for the benefits. The cost of the permanent benefits is

determined under a formula provided in the regulations that is based in part on the

increase in the employee's deemed death benefit during the year. One of the factors

used for determining the deemed death benefit is "the net level premium reserve at the

end of that policy year for all benefits provided to the employee by the policy or, if

greater, the cash value of the policy at the end of that policy year." Amendments to the

regulations under § 79 were proposed on February 13, 2004 (69 FR 7384) that would

delete the term “cash value” from the formula for determining the cost of permanent

benefits in § 1.79-1(d) and substitute the term “fair market value.” The proposed

regulations would apply to permanent benefits provided on or after February 13, 2004.
 3

(3) Transfers Under § 83(a). Section 83(a) provides that, when property is

transferred to any person in connection with the performance of services, the service

provider must include in gross income (as compensation income) the excess of the fair

market value of the property, determined without regard to lapse restrictions (such as

life insurance contract surrender charges), and determined at the first time that the

transferee's rights in the property are either transferable or not subject to a substantial

risk of forfeiture (i.e., when those rights become "substantially vested"), over the amount

(if any) paid for the property. Section 1.83-3(e) of the regulations provides that, in the

case of a transfer of a life insurance contract, retirement income contract, endowment

contract, or other contract providing life insurance protection, only the cash surrender

value of the contract is considered to be property. Amendments to the regulations

under § 83 were proposed on February 13, 2004 (69 FR 7384) that would provide that,

in the case of a transfer of an insurance contract, retirement income contract,

endowment contract, or other contract providing life insurance protection, the policy

cash value and all other rights under the contract (including any supplemental

agreements, whether or not guaranteed), other than current insurance protection, are

treated as property for purposes of § 83. The proposed regulations would apply to

transfers that occur on or after February 13, 2004 (with an exception for any contract

that was part of a split-dollar arrangement entered into on or before September 17,

2003, and which is not materially modified after that date).

(4) Contributions To and Distributions From Nonexempt Employees’ Trusts.

Section 402(b)(1) provides that contributions to an employees’ trust made by an

employer during a taxable year of the employer which ends with or within a taxable year
 4

of the trust for which the trust is not exempt from tax under § 501(a) are included in the

gross income of the employee in accordance with § 83 (relating to property transferred

in connection with the performance of services), except that the value of the employee’s

interest in the trust is substituted for the fair market value of the property for purposes of

applying § 83. Section 1.402(b)-1(a) of the regulations provides that any contributions

to a nonexempt trust by an employer during a taxable year of the employer which ends

within or with a taxable year of the trust shall be included as compensation in the gross

income of the employee for the employee’s taxable year during which the contribution is

made, but only to the extent that the employee’s interest in such contribution is

substantially vested (within the meaning of § 1.83-3(b)) at the time the contribution is

made.

Section 1.402(b)-1(b)(1) of the regulations provides that if rights of an employee

under a trust become substantially vested during a taxable year of the employee and a

taxable year for which the trust is not exempt under § 501(a) ends with or within such

year, the value of the employee’s interest in the trust on the date of such change

(substantially nonvested to substantially vested) is included in the employee’s gross

income for that taxable year. Section 1.402(b)-1(b)(2)(i) provides that the term “the

value of the employee’s interest in a trust” means the amount of the employee’s

beneficial interest in the net fair market value of all the assets in the trust as of any date

on which some or all of the employee’s interest in the trust becomes substantially

vested. The net fair market value of all the assets in the trust is the total amount of the

fair market values (determined without regard to any lapse restriction, as defined in §

1.83-3(h)) of all the assets in the trust, less the amount of all the liabilities to which such
 5

assets are subject or which the trust has assumed (other than the rights of any

employee in such assets), as of the date on which some or all of the employee’s interest

in the trust becomes substantially vested.

Section 402(b)(2) and § 1.402(b)-1(c) provide that any amount actually

distributed or made available to any distributee by an employee’s trust in a taxable year

in which it is not exempt under § 501(a) is taxable under § 72 (relating to annuities) to

the distributee in the taxable year in which it is so distributed or made available. If, for

example, the distribution consists of an annuity contract, the amount of the distribution

is considered to be the entire value of the contract at the time of the distribution. Such

value is includible in the gross income of the distributee to the extent that such value

exceeds the investment in the contract, determined by applying § 72. The distributions

are included in income under the rules of § 72 whether or not the employee’s rights in

the contributions become substantially vested beforehand.

Section 402(b)(4)(A) provides that, if one of the reasons a trust is not exempt

from tax under § 501(a) is the failure of the plan of which it is a part to meet the

requirements of § 401(a)(26) or 410(b), then a highly compensated employee shall, in

lieu of the amount determined under § 402(b)(1) or under § 402(b)(2), include in gross

income for the taxable year with or within which the taxable year of the trust ends an

amount equal to the vested accrued benefit of such employee (other than the

employee’s investment in the contract) as of the close of such taxable year of the trust.

.02 Prior Guidance Regarding Fair Market Value

(1) Rev. Rul. 59-195 - Interpolated Terminal Reserve. Rev. Rul. 59-195, 1959-

1 C.B. 18, addressed the determination of the fair market value of a policy in a situation
 6

in which an employer sold to an employee a life insurance contract on which premiums

were still due. The revenue ruling held that, for purposes of computing the employee’s

taxable gain in the year of the purchase, the value of the contract should be determined

using the approach of § 25.2512-6 of the Gift Tax Regulations. Under that regulation,

the value of a life insurance contract that has been in force for some time and on which

further premium payments are to be made is not its cash surrender value, but, rather,

the interpolated terminal reserve as of the date of sale plus the proportionate part of any

employer-paid unearned premiums. Section 25.2512-6 also provides that if "because of

the unusual nature of the contract such approximation is not reasonably close to the full

value, this method may not be used." Thus, this method is appropriate only where the

reserve reflects the value of all of the relevant features of the policy.

(2) Notice 89-25 – Tax Reserves. Q&A-10 of Notice 89-25, 1989-1 C.B. 662,

described a distribution from a qualified plan of a life insurance policy with a value

substantially higher than the cash surrender value stated in the policy. The notice

concluded that the practice of using cash surrender value as fair market value is not

appropriate where the total policy reserves, including life insurance reserves (if any)

computed under § 807(d), together with any reserves for advance premiums, dividend

accumulations, etc., represent a much more accurate approximation of the policy's fair

market value.

(3) Rev. Proc. 2004-16 – Safe Harbor for Determining Fair Market Value. Rev.

Proc. 2004-16, 2004-10 I.R.B. 559, provided a safe harbor for determining fair market

value of variable and non-variable contracts for purposes of applying the rules under the

proposed regulations issued under §§ 79, 83, and 402(a). The safe harbor for non-
 7

variable contracts set forth in Rev. Proc. 2004-16 permitted the use of the contract’s

cash value without reduction for surrender charges as the fair market value so long as

this cash value is at least equal to the sum of: (1) the premiums paid, plus (2) interest,

dividends or other credits, minus (3) reasonable mortality and other reasonable charges

actually charged by the date of determination (e.g., date of the transfer or distribution)

that are expected to be paid. In those cases where the contract is a variable contract

(as defined in § 817(d)), cash value without reduction for surrender charges may be

treated as the fair market value of the contract provided such cash value is at least

equal to the sum of: (1) the premiums paid, plus (2) all adjustments made with respect

to those premiums during that period (whether under the contract or otherwise) that

reflect investment return and the current market value of segregated asset accounts,

minus (3) reasonable mortality and other reasonable charges actually charged by the

date of determination (e.g., date of the transfer or distribution) that are expected to be

paid.

.03 Need For Further Guidance. After the issuance of Rev. Proc. 2004-16, the

Service received comments concerning the safe harbors set forth in that revenue

procedure. Commentators asserted that the formulas did not function well for certain

types of traditional policies. In addition, commentators were concerned about the

possible double-counting of dividends under the formulas, and the fact that the formulas

did not make an explicit adjustment for surrender charges, withdrawals, or distributions.

The Service has determined that adjustments to the safe harbors are appropriate.
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SECTION 3. GUIDANCE FOR DETERMINING FAIR MARKET VALUE

.01 Safe Harbor Formulas for Fair Market Value. This revenue procedure

provides two safe harbor formulas that, if used to determine the value of an insurance

contract, retirement income contract, endowment contract, or other contract providing

life insurance protection that is distributed or otherwise transferred from a qualified plan,

will meet the definition of fair market value for purposes of § 402(a). These safe harbor

formulas will also meet the definition of fair market value for purposes of §§ 79, 83, and

402(b) and, in addition, will meet the definition of vested accrued benefit for purposes of

§ 402(b)(4)(A).

.02 Safe Harbor for Non-Variable Contracts. Except as provided in section 3.03

of this revenue procedure (which applies only to variable contracts), the fair market

value of an insurance contract, retirement income contract, endowment contract, or

other contract providing life insurance protection may be measured as the greater of: A)

the sum of the interpolated terminal reserve and any unearned premiums plus a pro rata

portion of a reasonable estimate of dividends expected to be paid for that policy year

based on company experience, and B) the product of the PERC amount (the amount

described in the following sentence based on premiums, earnings, and reasonable

charges) and the applicable Average Surrender Factor described in section 3.04 of this

revenue procedure. The PERC amount is the aggregate of: (1) the premiums paid from

the date of issue through the valuation date without reduction for dividends that offset

those premiums, plus (2) dividends applied to purchase paid-up insurance prior to the

valuation date, plus (3) any amounts credited (or otherwise made available) to the

policyholder with respect to premiums, including interest and similar income items
 9

(whether credited or made available under the contract or to some other account), but

not including dividends used to offset premiums and dividends used to purchase paid

up insurance, minus (4) explicit or implicit reasonable mortality charges and reasonable

charges (other than mortality charges), but only if those charges are actually charged on

or before the valuation date and those charges are not expected to be refunded,

rebated, or otherwise reversed at a later date, minus (5) any distributions (including

distributions of dividends and dividends held on account), withdrawals, or partial

surrenders taken prior to the valuation date.

.03 Safe Harbor for Variable Contracts. If the insurance contract, retirement

income contract, endowment contract, or other contract providing life insurance

protection being valued is a variable contract (as defined in § 817(d)), the fair market

value may be measured as the greater of: A) the sum of the interpolated terminal

reserve and any unearned premiums plus a pro rata portion of a reasonable estimate of

dividends expected to be paid for that policy year based on company experience, and

B) the product of the variable PERC amount (the amount described in the following

sentence based on premiums, earnings, and reasonable charges) and the applicable

Average Surrender Factor described in section 3.04 of this revenue procedure. The

variable PERC amount is the aggregate of: (1) the premiums paid from the date of issue

through the valuation date without reduction for dividends that offset those premiums,

plus (2) dividends applied to increase the value of the contract (including dividends used

to purchase paid-up insurance) prior to the valuation date, plus or minus (3) all

adjustments (whether credited or made available under the contract or to some other

account) that reflect the investment return and the market value of segregated asset
 10

accounts, minus (4) explicit or implicit reasonable mortality charges and reasonable

charges (other than mortality charges), but only if those charges are actually charged on

or before the valuation date and those charges are not expected to be refunded,

rebated, or otherwise reversed at a later date, minus (5) any distributions (including

distributions of dividends and dividends held on account), withdrawals, or partial

surrenders taken prior to the valuation date.

.04 Average Surrender Factor.

(1) Sections 79, 83, and 402(b). The Average Surrender Factor for purposes of

§§ 79, 83, and 402(b) (for which no adjustment for potential surrender charges is

permitted) is 1.00.

(2) Qualified plans. In the case of a distribution or sale from a qualified plan, if

the contract provides for explicit surrender charges, the Average Surrender Factor is the

unweighted average of the applicable surrender factors over the 10 years beginning

with the policy year of the distribution or sale. For this purpose, the applicable

surrender factor for a policy year is equal to the greater of 0.70 and a fraction, the

numerator of which is the projected amount of cash that would be available if the policy

were surrendered on the first day of the policy year (or, in the case of the policy year of

the distribution or sale, the amount of cash that was actually available on the first day of

that policy year) and the denominator of which is the projected (or actual) PERC amount

as of that same date. The applicable surrender factor for a year in which there is no

surrender charge is 1.00. A surrender charge is permitted to be taken into account

under section 3.04 of this revenue procedure only if it is contractually specified at

issuance and expressed in the form of nonincreasing percentages or amounts.

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.05 Application of Safe Harbor Formulas. The formulas set forth in sections 3.02

and 3.03 of this revenue procedure must be interpreted in a reasonable manner,

consistent with the purpose of identifying the fair market value of a contract. Thus, for

example, if income is calculated with respect to premiums paid under the contract, that

amount must be included in item (3) of the formulas, even if the income can only be

realized through an exchange right that gives rise to a springing cash value under

another policy. Similarly, if a mortality charge or other amount charged under a contract

can be expected to be directly or indirectly returned to the contractholder (whether

through the contract, a supplemental agreement, or under a verbal understanding and

regardless of whether there is a guarantee), the charge is not permitted to be subtracted

under item (4) in the formulas. In addition, a surrender charge cannot be taken into

account in determining an average surrender factor if it may be waived or otherwise

avoided or was created for purposes of the transfer or distribution. Furthermore, at no

time are these rules to be interpreted in a manner that allows the use of these formulas

to understate the fair market value of the life insurance contracts and associated

distributions or transfers. For example, if the insurance contract has not been in force

for some time, the value of the contract is best established through the sale of the

particular insurance contract by the insurance company (i.e., as the premiums paid for

that contract).

.06 Date as of Which Fair Market Value is Determined. In the case of a

distribution or sale of a contract from a qualified plan, the date as of which the fair

market value is to be determined is the date of that distribution or sale. The date of

determination in the case of the provision of permanent benefits subject to § 79 is the

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date those benefits are provided. The date of determination in the case of a transfer of

an insurance contract subject to § 83 is the date on which fair market value must be

determined under the rules of § 83. The date of determination in the case of a non-

exempt employees’ trust under § 402(b) is the date on which fair market value must be

determined under the rules of § 402(b).

SECTION 4. ADDITIONAL AMOUNTS THAT MUST BE INCLUDED IN INCOME

.01 Treatment of Dividends Held on Deposit. Dividends held on deposit with

respect to an insurance contract are not included in the fair market value of the contract.

However, such dividends are taxable income to the employee or service provider at the

time the rights to those dividends are transferred to that individual. For example, if a

qualified plan distributes a contract to an employee along with the rights to dividends

held on deposit with respect to that contract, the employee must take into income both

the fair market value of the contract and the value of the dividends held on the deposit.

This is the case regardless of whether the dividends on deposit are paid directly to the

employee at the time the contract is distributed or merely made available for payment at

a later time.

.02 Treatment of Loans. If a loan (including a loan secured by the cash value of

a life insurance contract) is made to an employee or other service provider in

connection with the performance of services, to the extent the debt owed by the

employee or other service provider is terminated upon distribution or transfer of the

collateral, the terminated loan or debt amount constitutes an additional distribution to

the employee or service provider at that time. For this purpose, it is irrelevant whether
 13

the loan is described as having been forgiven, canceled, satisfied, extinguished, or

otherwise offset, provided that the loan no longer exists after the distribution or transfer.

For example, if a life insurance contract with a fair market value of $100,000 (without

regard to any debt) is collateral for a policy loan of $30,000 (borrowed by the employer,

who then lends the $30,000 to the employee) prior to the distribution or transfer of the

contract, and the loan to the employee no longer exists after the distribution or transfer

so that the amount distributed is $70,000 ($100,000 - $30,000), the entire $100,000

must be taken into account by the employee. If a participant receives a loan from a life

insurance contract held by a qualified plan (or other plan subject to the rules of § 72(p))

and the contract is subsequently distributed to the participant in satisfaction of the

participant's benefit under the plan, the reduction in the value of the distribution in order

to repay the participant's loan from the plan constitutes a plan loan offset amount, which

is treated as a distribution from the plan. See § 1.72(p)-1, Q&A-13(b).

SECTION 5. EFFECTIVE DATE

This revenue procedure applies to distributions, sales, and other transfers made

on or after February 13, 2004, to permanent benefits within the meaning of § 1.79-0

provided on or after February 13, 2004, and to non-exempt employees’ trusts under §

402(b) for periods on or after February 13, 2004. However, for periods before May 1,

2005, taxpayers may rely on the safe harbors of this revenue procedure and for periods

on or after February 13, 2004, and before May 1, 2005, taxpayers may also rely on the

safe harbors in Rev. Proc. 2004-16.

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SECTION 6. EFFECT ON OTHER DOCUMENTS

Rev. Proc. 2004-16 is modified and superseded.

DRAFTING INFORMATION

The principal authors of this revenue procedure are Bruce Perlin and Linda

Marshall, Office of Division Counsel/Associate Chief Counsel (Tax Exempt and

Government Entities) and Larry Isaacs of the Employee Plans, Tax Exempt and

Government Entities Division. For further information regarding this revenue procedure

as it pertains to § 402(a), please contact Bruce Perlin or Linda Marshall at (202) 622-

6090 (not a toll-free number) or Larry Isaacs at (202) 283-9888 (not a toll-free number)

or contact the Employee Plans’ taxpayer assistance telephone service at (877) 829-

5500 (a toll-free number) between the hours of 8:00 a.m. and 6:30 p.m. Eastern Time,

Monday through Friday. For further information regarding this revenue procedure as it

pertains to § 79, please contact Betty Clary of the Office of Division Counsel/Associate

Chief Counsel (Tax Exempt and Government Entities) at (202) 622-6080 (not a toll-free

number). For further information regarding this revenue procedure as it pertains to §§

83 and 402(b), please contact Robert Misner of the Office of Division Counsel/Associate

Chief Counsel (Tax Exempt and Government Entities) at (202) 622-6030 (not a toll-free

number).